Yeditepe University

Institute of Social Sciences

Finance Doctorate in Business Administration

Investment Analysis & Portfolio Management

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Reilly&Brown

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“The Investment Setting”

Chapter 1
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Prof. Abdulgaffar Ağaoğlu

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Sebahattin Demir

Istanbul

2016

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 Table of Contents

1. Absract 3
2. Investment, risk and return 4
3. Measuring historical returns 4
4. Measuring expected rate of return 4

5. Measuring the risk of expected rate of retun 4

6. Determinant od required rates of return 5

7. Relationship between risk and return 6

8. Questions and Answers 7

9. Problems and Answers 8

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10. Glassory 9

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 1. Abstract

In this chapter, firstly investment, return and risk terms will be defined. Then expected and
historical rates of returns for an individual asset or a portfolio of assets will be formulated. Later
risk measurement will be considered for an investment. After that the factors that determine the
required rate of return for an investment will be discussed. In the final section the reasons that
cause changes in an asset’s required rate of return over time will be considered.

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 2. Investment, risk and return

The trade-off of present consumption for a higher level of future consumption is the reason for
saving. What you do with the savings to make them increase over time is investment.
We have alternative investment and saving assets, in order to select the asset it requires to estimate
and evaluate the expected risk return trade-offs for the alternative investments available.
Therefore, we must understand how to measure the rate of return and the risk involved in an
investment accurately. Following the presentation of measures of historical rates of return and risk,
we turn to estimating the expected rate of return for an investment.
3. Measuring historical retuns
a) Holding Period Return
The period during which you own an investment is called its holding period, and the return for that
period is the holding period return (HPR). In this example, the HPR is 1.10, calculated as follows:

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HPR= Ending Value of Investment/ Beginning Value of Investment

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Although HPR helps us express the change in value of an investment, investors generally evaluate

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returns in percentage terms on an annual basis. This conversion to annual percentage rates makes

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it easier to directly compare alternative investments that have markedly different characteristics.
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The first step in converting an HPR to an annual percentage rate is to derive a percentage return,
referred to as the holding period yield (HPY). The HPY is equal to the HPR minus 1.
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b) Computing mean historical returns

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The first is the arithmetic mean return the second is the geometric mean return. AM is best used as
an expected value for an individual year, while the GM is the best measure of long-term
performance since it measures the compound annual rate of return for the asset being measured.
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4. Measuring expected rate of return

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Risk is the uncertainty that an investment will earn its expected rate of return. An investor
determines how certain the expected rate of return on an investment is by analyzing estimates of
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possible returns. To do this, the investor assigns probability values to all possible returns.
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5. Measuring the risk of expected rate of return

Measures of risk (uncertainty) are;
Variance The larger the variance for an expected rate of return, the greater the dispersion of
expected returns and the greater the uncertainty, or risk, of the investment.
Standard Deviation The standard deviation is the square root of the variance.
Relative Measure of Risk If conditions for two or more investment alternatives are not similar—
that is, if there are major differences in the expected rates of return—it is necessary to use a

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 measure of relative variability to indicate risk per unit of expected return. A widely used relative
measure of risk is the coefficient of variation (CV), calculated as follows;

6. Determinants of Required Rates of Return

There are 3 determinants of required rates of return; (1) the time value of money during the period
of investment, (2) the expected rate of inflation during the period, and (3) the risk involved.
a) Real risk free rate
The real risk-free rate (RRFR) is the basic interest rate, assuming no inflation and no uncertainty
about future flows. Two factors, one subjective and one objective, influence this exchange price.
The subjective factor is the time preference of individuals for the consumption of income. The
strength of the human desire for current consumption influences the rate of compensation

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required. The objective factor that influences the RRFR is the set of investment opportunities

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available in the economy. A rapidly growing economy produces more and better opportunities to

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invest funds and experience positive rates of return.

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b) Factors influencing nominal risk-free rate
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Two other factors influence the nominal risk-free rate (NRFR): (1) the relative ease or tightness in
the capital markets, and (2) the expected rate of inflation. Capital markets purpose is to bring
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together investors who want to invest savings with companies or governments who need capital to
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expand or to finance budget deficits. And if investors expected the price level to increase (an
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increase in the inflation rate) during the investment period, they would require the rate of return to
include compensation for the expected rate of inflation.
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c) Risk premium
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Most investors require higher rates of return on investments if they perceive that there is any
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uncertainty about the expected rate of return. This increase in the required rate of return over the
NRFR is the risk premium (RP). The major sources of uncertainty are; (1) business risk, (2)
financial risk (leverage), (3) liquidity risk, (4) exchange rate risk, and (5) country (political) risk.

Markowitz and Sharpe showed that the relevant risk measure for an individual asset is its
comovement with the market portfolio. This comovement, which is measured by an asset’s
covariance with the market portfolio, is referred to as an asset’s systematic risk, the portion of an
individual asset’s total variance that is attributable to the variability of the total market portfolio.

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 In addition, individual assets have variance that is unrelated to the market portfolio (the asset’s
nonmarket variance) that is due to the asset’s unique features. This nonmarket variance is called
unsystematic risk, and it is generally considered unimportant because it is eliminated in a large,
diversified portfolio. Therefore, under these assumptions, the risk premium for an individual
earning asset is a function of the asset’s systematic risk with the aggregate market portfolio of
risky assets. The measure of an asset’s systematic risk is referred to as its beta:
Risk Premium = f (Systematic Market Risk)
7. Relationship between risk and return

Investors increase their required rates of return as perceived risk (uncertainty) increases. The line
that reflects the combination of risk and return available on alternative investments is referred to
as the security market line (SML). The relationship between risk and the required rate of return for
an investment can change in three ways:

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a) Movement along the SML; demonstrates a change in the risk characteristics of a specific

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investment, such as a change in its business risk, its financial risk, or its systematic risk (its

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beta). This change affects only the individual investment.

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b) Change in the slope of the SML; occurs in response to a change in the attitudes of investors
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toward risk. Such a change demonstrates that investors want either higher or lower rates of
return for the same intrinsic risk. This is also described as a change in the market risk
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premium (Rm − NRFR). A change in the market risk premium will affect all risky
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investments.
c) Shift in the SML; reflects a change in expected real growth, a change in market conditions
(such as ease or tightness of money), or a change in the expected rate of inflation. Again,
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such a change will affect all investments.

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8. Questions and Answers

Question 10: You own stock in the Gentry Company, and you read in the financial press that a
recent bond offering has raised the firm’s debt/equity ratio from 35 percent to 55 percent. Discuss
the effect of this change on the variability of the firm’s net income stream, other factors being

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 constant. Discuss how this change would affect your required rate of return on the common stock
of the Gentry Company.
Answer: The increased use of debt increases the fixed interest payment. Since this fixed
ontractual payment will increase, the residual earnings (net income) will become more variable.
The required rate of return on the stock will change since the financial risk has increased.
Question 12: Explain why you would change your nominal required rate of return if you expected
the rate of inflation to go from 0 (no inflation) to 4 percent. Give an example of what would
happen if you did not change your required rate of return under these conditions.
Answer: If a market’s real RFR is, say, 3 percent, the investor will require a 3 percent return on an
investment since this will compensate him for deferring consumption. However, if the inflation
rate is 4 percent, the investor would be worse off in real terms if he invests at a rate of return of 4
percent - e.g., you would receive $103, but the cost of $100 worth of goods at the beginning of the

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year would be $104 at the end of the year, which means you could consume less real goods. Thus,

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for an investment to be desirable, it should have a return of 7.12 percent [(1.03 x 1.04) - 1], or an

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approximate return of 7 percent (3% + 4%).

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Question 13: Assume the expected long-run growth rate of the economy increased by 1 percent
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and the expected rate of inflation increased by 4 percent. What would happen to the required rates
of return on government bonds and common stocks? Show graphically how the effects of these
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changes would differ between these alternative investments.

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Answer: Both changes cause an increase in the required return on all investments. Specifically, an
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increase in the real growth rate will cause an increase in the economy’s RFR because of a higher
level of investment opportunities. In addition, the increase in the rate of inflation will result in an
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increase in the nominal RFR. Because both changes affect the nominal RFR, they will cause an
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equal increase in the required return on all investments of 5 percent.

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9. Problems and Answers

Problem 10: You read in BusinessWeek that a panel of economists has estimated that the long-run
real growth rate of the U.S. economy over the next five-year period will average 3 percent. In
addition, a bank newsletter estimates that the average annual rate of inflation during this five-year

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 period will be about 4 percent. What nominal rate of return would you expect on U.S. government
T-bills during this period?
Answer: NRFR = (1 + .03) (1 + .04) – 1 = 1.0712 – 1 = .0712
(An approximation would be growth rate plus inflation rate or .03 + .04 = .07.)
Problem 11: What would your required rate of return be on common stocks if you wanted a 5
percent risk premium to own common stocks given what you know from Problem 10? If common
stock investors became more risk averse, what would happen to the required rate of return on
common stocks? What would be the impact on stock prices?
Answer: Return on common stock = (1 + .0712) (1 + .05) – 1 = 1.1248 – 1 = .1248 or 12.48%
(An approximation would be .03 + .04 + .05 = .12 or 12%.)
As an investor becomes more risk averse, the investor will require a larger risk premium to
own common stock. As risk premium increases, so too will required rate of return. In order

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to achieve the higher rate of return, stock prices should decline.

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Problem 12: Assume that the consensus required rate of return on common stocks is 14 percent.

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In addition, you read in Fortune that the expected rate of inflation is 5 percent and the estimated

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long-term real growth rate of the economy is 3 percent. What interest ratewould you expect on
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U.S. government T-bills? What is the approximate risk premium for common stocks implied by
these data?
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Answer: Nominal rate on T-bills (or risk-free rate) = (1 + .03) (1 + .05) – 1 = 1.0815 – 1 = .0815
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(An approximation would be .03 + .05 = .08.)

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The required rate of return on common stock is equal to the risk-free rate plus a risk premium.
Therefore the approximate risk premium for common stocks implied by these data is:
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0.14 - .0815 = .0585 or 5.85%. (An approximation would be .14 - .08 = .06.)
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10. Glassory

Coefficient of variation (CV): A measure of relative variability that indicates risk per unit of
return. It is equal to: standard deviation divided by the mean value. When used in investments, it is
equal to: standard deviation of returns divided by the expected rate of return.

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 Expected rate of return: The return that analysts’ calculations suggest a security should provide,
based on the market’s rate of return during the period and the security’s relationship to the market.
Holding period return (HPR): The total return from an investment, including all sources of
income, for a given period of time. A value of 1.0 indicates no gain or loss. Equal to ending
wealth/beginning wealth.
Holding period yield (HPY): The total return from an investment for a given period of time
stated as a percentage; equal to HPR-1.
Investment: The current commitment of dollars for a period of time in order to derive future
payments that will compensate the investor for the time the funds are committed, the expected rate
of inflation, and the uncertainty of future payments.
Real risk-free rate (RRFR): The basic interest rate with no accommodation for inflation or
uncertainty; the pure time value of money. Required rate of return: The return that compensates

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investors for their time, the expected rate of inflation, and the uncertainty of the return.

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Risk: The uncertainty that an investment will earn its expected rate of return.

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Risk averse: The assumption about investors that they will choose the least risky alternative, all

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else being equal.
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Risk premium (RP): The increase over the nominal risk-free rate that investors demand as
compensation for an investment’s uncertainty.
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Standard deviation: A measure of variability equal to the square root of the variance.
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Variance: A measure of variability equal to the sum of the squares of a return’s deviation from the
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mean, divided by the total number of returns.

Systematic risk: The variability of returns that is due to macroeconomic factors that affect all
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risky assets. Because it affects all risky assets, it cannot be eliminated by diversification.
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Unsystematic risk: Risk that is unique to an asset, derived from its particular characteristics. It
can be eliminated in a diversified portfolio.
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